INVESTING IN COMMERCIAL property can be a long and complex affair. Buyers have to go through the process of identifying properties, negotiating with sellers and arranging financing, all of which can take months. That’s changing now, as a host of new indexes are set to make gaining or reducing exposure to commercial real estate far simpler for institutional investors.
Several of these benchmarks give investors opportunities to make bets, using derivatives, on specific portions of the commercial real estate universe. Radar Logic, a firm that publishes an index of residential real estate prices, is planning to introduce a similar benchmark tracking daily commercial property prices for 25 U.S. metropolitan areas. In May lodging analytics firm HQuant launched the HQuant lodging index, allowing investors for the first time to take long and short positions on the hotel sector. And in September, Moody’s Investors Service and REAL Brokerage, a division of Real Estate Analytics, introduced the Moody’s/REAL commercial property prices indexes, which track prices of specific properties over a number of years.
Derivatives based on these indexes can compress the lengthy process of buying and selling commercial properties into synthetic transactions that take a week or less to close.
“An investor can wake up and decide that he wants to reduce his exposure to the Washington, D.C., office market, and instead of liquidating his assets, he can short the Washington office index through a swap,” says Neal Elkin, president of REAL Brokerage.
The 29 Moody’s/REAL indexes are divided by metropolitan area, published monthly and calculated using repeat sales data on individual properties. There’s also a monthly aggregate index for all property types and quarterly indexes tracking office, retail, industrial and multifamily properties. REAL Brokerage serves as an intermediary, matching buyers and sellers of derivatives based on the indexes.
Investors in commercial-real-estate debt are also benefiting from advances in financial engineering. One big innovation is the CMBX index, the first benchmark of commercial mortgage-backed securities, launched last year by Markit Group. The index lets sophisticated investors make nuanced bets on the debt backing commercial properties. A CMBS investor who believes that bonds issued in a certain year are more likely to default because of risky underwriting, for example, can home in on these securities by trading credit default swaps on parts of the CMBX.
“Investors can express different credit opinions on bonds or companies, including an opinion that things are potentially going to be worse,” says Spencer Haber, founder of commercial-real-estate investment manager H/2 Capital Partners. “In the old model you could buy or sell a bond. Those were your two choices.”
The development of these indexes caps nearly two decades of progress toward greater liquidity and flexibility for commercial-real-estate investors. Real estate syndication partnerships and real estate investment trusts have long pooled interests in properties to spread risk. Indexes focusing on specific regions and property types offer investors even more options for customized, sophisticated plays. And securitization for many years has contributed to far-more-liquid markets for commercial-real-estate debt. The emergence of a derivatives market is the next logical step. It’s also a sign that the sector is now a mainstream asset class.
“As the debt and equity markets for commercial real estate went from being fairly opaque private markets to being more transparent public markets, the amount of information around risk and pricing grew,” explains Haber. “Real estate debt and equity went from a nontraded asset class to a market where you could turn on a trading screen and get some form of proxy for where real estate debt and equity could be priced.”
Derivatives markets should boost overall investor participation in commercial real estate. But even though the process of gaining and reducing exposure to commercial properties is becoming more streamlined, the developers of indexes and derivatives based on them still need to familiarize investors with the intricacies of these markets. Many investment managers who want to plunge into commercial real estate will first need to learn about the process of using derivatives, then make changes to fund prospectuses and inform their clients about what’s being done.
“While there is enormous pent-up demand,” says Elkin, “the challenge is that we need to educate our clients about how this works.”
